Taxation of individual income in Estonia is generally straightforward and there are few exceptions. Since the new defence tax essentially creates a parallel system to the current income tax, it would be wise to take note of what the coming years may bring. The provisions governing the defence tax largely refer to the Income Tax Act (ITA), which covers the tax base and withholding rules.

Income of resident individuals

According to the draft legislation, the income of resident individuals will be subject to the defence tax, defined in accordance with sections 12–22 of the ITA. This means that the defence tax will apply to salary income, business income, income from the sale of assets, rental income, interest, dividends, pensions, and other similar types of income. Under Section 6 of the ITA, the income of a resident individual is taxed on both domestic and foreign income.

Certain deductions provided for in the ITA will not apply when calculating defence tax liability:

  • the right of individuals to deduct up to EUR 5,000 annually from income derived from the sale of felled timber or the right to fell trees on property they own, as well as from Natura 2000 private forest land support
  • the right of individuals to deduct 20% of rental income to cover rental-related expenses.

For the sake of broad-based taxation, certain mandatory and voluntary pension payments meeting specific criteria will also be taxed under the defence tax.

The defence tax will also be imposed on the foreign income of Estonian residents, which is exempt from income tax under the exemption method used to prevent double taxation, such as income from foreign employment that has already been taxed abroad. Similarly, foreign dividends will also be taxed.

While it makes sense to tax dividends in Estonia, taxing foreign-earned wages seems rather ill-conceived. Estonia has thousands of cross-border workers and keeping them as Estonian tax residents should be one of the state’s top priorities. However, this new tax gives them an additional reason to register themselves permanently as tax residents in Finland or Sweden (where taxes on wages are already paid). This raises the question of whether and how we should tax cross-border workers considering that if their wages have already been taxed abroad and they only return to Estonia for holidays, we should avoid driving these people away (especially when changing tax residency is easy).

At the same time, the current draft law includes an exemption for investment accounts, and at least for now, dividends and interest paid into such accounts are not taxed separately. However, a 2% defence tax will apply to withdrawals from an investment account exceeding the amounts contributed. If an investment account has not been created, but interest or dividends are received directly by an individual, it would be advisable to consider setting up an investment account. Whether the investment account exemption will remain permanent is something only time will tell.

Defence tax calculation

Interestingly, when drafting the law, the Ministry of Finance did not take into account the new EUR 700 income tax exemption in their examples, so here is an example based on the draft.

Example of taxation of a gross income of EUR 1,000 in 2026:

Income tax calculation: 1,000 – 654 (tax-free income) – 16 (unemployment insurance) – 20 (pension contribution) = 310. Taxable income is 310, from which 22% income tax is deducted, amounting to 68.2.

Defence tax calculation: EUR 1,000 x 0.02 = 20.

Tax withholding procedure

Defence tax withholding will occur alongside income tax withholding. The tax withholder will be the legal entity or entrepreneur operating in Estonia who makes the payments. The withheld tax must be transferred to the Tax and Customs Board by the 10th day of the month following the payment.

In conclusion, the intention of the defence tax is for it to be a broad-based and “temporary” tax, covering largely the same types of income already taxed under the income tax system. In essence, it can be said that this is simply an additional income tax obligation, but stricter. The lack of exemptions and the fact that it will be imposed from the first euro earned will undoubtedly lead to many disputes in the future.